RH: Redefining Luxury And Scaling New Heights In Global Furnishings Industry

The $252 billion US furniture market is fragmented, with no entity securing more than a 10% share. Prominent mass-market retailers, including Ashley, Ethan Allen (ETD), La-Z-Boy (LZB), and IKEA, comprise a significant portion of the market. Within the crowded premium furniture sector, firms like Arhaus (ARHS), Herman Miller, West Elm, the Citizenry, and CB2 operate as ‘in-betweeners’, offering premium furnishings but failing to carve a unique niche to differentiate further. While at the same time, these brands lack size, falling short of achieving significant economies of scale. CEO Gary Friedman often alludes to this gap in the marketplace, affirming, “There are those with taste and no scale, and those with scale and no taste.”

While the $516 billion global furniture market alone has substantial untapped potential, RH’s leadership sees an opportunity to carve out its own path on a worldwide scale. The strategy isn’t to sell commoditized furniture but to construct an ecosystem brimming with sought-after products, services, and experiences – an arena where no competitor currently operates. This advantage is confirmed by a market-leading ~50% gross margins and 20%+ operating margins. Friedman is shaping a lifestyle brand infused with luxury and exclusivity, providing a private haven for those seeking respite from the pervasive exposure of personal lives in today’s social media era. This approach deviates from the undifferentiated premium furnishings competitors who cater to a relatively lower-end market segment, engaging in competition on the basis of cost or better product quality.

The RH Moat

The company possesses two significant, durable competitive advantages that are still in the early innings of its growth trajectory. Specifically, these strengths are rooted in brand prestige and a low-cost structural advantage.

Brand

Under the leadership of Gary Friedman, RH is carving a unique niche in the luxury market, transcending the traditional boundaries of the furnishings industry. Inspired by business giants like LVMH (OTCPK:LVMHF) and Apple (AAPL), Friedman is transforming RH into an exclusive lifestyle brand that offers more than just furniture. The company is evolving into a curator of lifestyles, blending products with immersive experiences, and selling an elevated lifestyle to high-net-worth individuals.

Unlike other retailers who have minimized their physical presence to focus on e-commerce, RH has increased its footprint with grand design galleries that serve as architectural masterpieces and a form of marketing. Competitors downsizing to streamline costs must compensate through traditional forms of digital and media advertising—a trap that RH has managed to sidestep, showcasing a sales & marketing expense of just 2% of sales for fiscal 2022, in sharp contrast to 12.7%, 6.7%, and 3% for Ethan Allen, Williams-Sonoma, and Arhaus, respectively.

RH’s innovative strategies include the production of Source Books, which serve as physical extensions of the brand, and a membership model that offers discounts and complimentary interior design services for a small annual fee of $175. This model enhances customer experience and product value perception, fostering brand loyalty and disrupting traditional buying patterns.

Echoing Apple’s ethos, RH aims to create an integrated ecosystem of products, locations, and services. The company is extending its reach beyond furniture with the RH Guesthouse, the forthcoming RH Bath House & Spa, and RH Residences, offering a holistic hospitality experience for luxury-seeking travelers. RH is also venturing into the chartering business with its custom-designed Gulfstream jets and super yacht.

As RH continues to expand its offerings, it is solidifying its position as a leader in design and architecture and exploring new markets that increase its potential for future earnings. The company’s innovative strategies have shown promising results, with average restaurant volumes nearing $10 million and significant business boosts when legacy galleries are revamped into new design galleries with integrated dining.

Low-Cost Operating Advantage

RH is leveraging its scale to develop a capital-efficient operating advantage that outperforms its peers. The company has overhauled its operating platform, reimagining its value chain from SKU strategy to logistics and distribution. It has also formed strategic partnerships with landlords and real estate developers, reducing capital requirements and enhancing return on capital.

RH has streamlined its operations over the past decade, simplifying its supply chain and reducing costs as the company grows. In 2016, RH launched initiatives to reorganize its operating platform and redesign its outlet and reverse logistics models. The company rationalized and reduced SKUs, eliminating lower-tier items that diluted its luxury positioning. This strategy improved inventory turnover rates and became a significant source of working capital.

RH also simplified its supply chain network, closing three distribution centers amounting to 2.25 million in square footage reductions and eliminating duplicate SKUs. The company’s membership model helped to eliminate sudden order spikes, relieving stress on the logistics network and reducing return rates, exchanges, and canceled orders.

Nearly 100% of RH’s core business is a direct-to-consumer model, freeing up valuable floor space for product display and minimizing risks such as theft and shrinkage. The company also rearchitected its legacy outlet and reverse logistics model, rerouting customer returns directly to its outlet network and reducing annual costs.

RH has taken control of the last-mile home delivery, reducing return and exchange volumes and improving the overall customer experience. The company sources its inventory directly from third-party vendors. In fiscal 2022, for instance, 75% of RH’s purchase dollar volume came from just 25 vendors. This strategy has effectively allowed RH to exploit a fragmented supplier landscape. It leverages its considerable bargaining power to negotiate favorable prices while exerting significant control over the process. This unique approach enables RH to reap the benefits of not owning the manufacturing process while mitigating some associated downsides.

RH has strategically reduced its capital obligations for its galleries by capitalizing on its financial strength and prestige. The company utilizes sale-leasebacks, enters joint ventures, and negotiates capital-friendly leasing deals. These strategies have significantly reduced occupancy costs and capital requirements, increasing free cash flow generation and return on invested total capital.

RH Management & Culture

Gary Friedman is the principal shareholder, possessing a hefty 21.2% stake in the company. The remaining executive officers and directors hold a combined 2.8% stake, with Eri Chaya, the President & Chief Creative and Merchandising Officer, holding the majority. Friedman’s base salary of $1.25 million has remained consistent since 2013. Moreover, he and the management team benefit from an annual performance-based cash incentive linked to adjusted income and a long-term equity incentive compensation plan involving stock options. Friedman’s resilience and preference for long-term returns over short-term gratification are evident in his leadership style. He is known for his candid evaluations of the company’s performance, taking personal ownership of both successes and failures. His commitment to excellence and vision for creating an iconic brand are key drivers of RH’s value creation.

I believe the CEO’s compensation structure is aligned with increasing shareholder value. For him to realize the value of his stock option package anytime soon, the stock price must surpass $500, $650, and $800 performance benchmarks by May 2029. Failure to achieve these goals by then would result in an extended waiting period, as the selling restrictions wouldn’t lift until 2041.

Capital Allocation

Shareholders should be pleased with management’s proficiency in capital allocation. Over the last six years, management has maintained an impressive average return on invested tangible capital (ROITC) of 27%. Throughout this period, virtually all of the generated free cash flow was reinvested into the business to stimulate long-term growth. This included the expansion of existing business operations, gallery transformation, and international development, as well as laying the groundwork for future high-quality revenue streams. During this time, the company’s $3.4 billion operating cash flow comfortably financed $1.8 billion in adjusted capital expenditures.

The company’s approach to leveraging debt has been strategic and assertive, aimed at enhancing shareholder value without overburdening the balance sheet. It has leveraged debt at 5x sustainable Levered Free Cash Flow (LFCF), maintaining an interest coverage ratio of 3x based on the TTM Normalized EBIT. Since 2017, management has issued $2 billion in net debt, facilitating $2.5 billion (40% of the current market cap) in timely buybacks.

These buybacks were executed when Gary and his team deemed the stock undervalued, resulting in a buyback strategy that bolstered intrinsic value per share. This disciplined repurchasing strategy reflects management’s comprehensive understanding of enhancing shareholder value.

The company’s debt maturity profile is well-staggered, with the only near-term obligations being convertible bonds due in 2023 and 2024, amounting to a manageable principal sum of $44 million. The next significant debt obligations are $2.5 billion term loans expiring in 2028. With the combination of $1.5 billion in excess cash and its own FCF generation machine, the business can pay these back comfortably.

Regarding mergers and acquisitions (M&A), the company has yet to deploy substantial capital in this way. In 2016, it acquired Waterworks for $117 million. Subsequently, in the winter of 2022, it expanded its custom atelier business by purchasing Dmitriy & Co and Jeup for an undisclosed amount, bolstering its bespoke furniture and upholstery engine.

Investment Cases

Case #1

RH is cultivating a robust business with two expanding durable competitive advantages and a long runway for growth.

RH is building a strong business with two growing competitive advantages and a long runway for growth. The company has transformed its brand image and operational efficiency over the last two decades and is now poised for growth through completing its domestic gallery transformation, global expansion, and launching new concepts.

RH has focused on cultivating operational efficiencies and replacing existing locations rather than entering new markets. The company has increased total square footage by 55% through the gallery transformation initiative, but the number of gallery locations has decreased from 70 to 67. This period of restructuring has allowed RH to refine its brand, develop sustainable, low-cost advantages, and foster significant operating leverage.

The first component of growth is the completion of transforming the remaining legacy galleries. The new galleries have superior economics, with revenues typically doubling and profits increasing even more after a transformation. The new design allows RH to display more furniture and attracts more traffic to the store. Transforming the remaining 35 legacy galleries, averaging 7.4k sq ft each, into new designs of around 38k sq ft could yield an extra $2.2 billion in sales, adding to the current $3.5 billion base. Given the 50% gross margins, most of these profits will translate into net profits. However, accounting for specific expenses like credit card charges (2-3% of sales) and Source Books (1-4% of sales), we’ll add an extra 5% to SG&A expenses. This results in a 45% profit margin or $1 billion in incremental profits. Considering a 10-15x multiple, this could add $10 billion to $15 billion to the market value.

The second driver is international expansion. RH recently launched its first international location in England and plans to establish galleries in Brussels, Paris, London, Milan, Sydney, Dusseldorf, Munich, and Madrid within the next two years. If RH mirrors LVMH’s sales ratio, with only 27% of sales from the US, it could reach a $21.1 billion run rate ($5.7B/27%). With a 30% operating margin based on management guidance, recent track record, and increased economies of scale, this equates to $6.3 billion in EBIT. Applying a 10-15x multiple, the future EV could range between $63 billion and $95 billion, about 11.5x the current valuation. This projection could see further upside if Wall Street catches the excitement and multiples surge. Furthermore, scaling operations could elevate the operating margin even more as costs get dispersed across a relatively large fixed asset base.

Lastly, RH is building new revenue streams, moving beyond selling products to selling places, services, and spaces. The company is experimenting with ventures such as the RH Guesthouse, an upscale restaurant and hospitality experience, and the RH Bath House & Spa.

The company has also expanded into luxury travel, offering two bespoke Gulfstream jets and a yacht for charter. Furthermore, RH Residencies plans to design and build fully furnished homes for the ultra-wealthy, extending the business beyond the home furnishings market into the housing market.

Case #2

Investors are not paying a significant premium for growth. The stock has little risk of permanent capital impairment, even if the anticipated call option-like growth drivers do not fully materialize.

Despite the impressive potential for growth, the essence of investing always hinges on reducing the risk of financial loss and a permanent loss of capital. Thus, ensuring that I pay a reasonable price is paramount. Ultimately, expanding sustainable competitive advantages within a business and paying an optimal price ensures an adequate safety margin for the investment.

I believe that with RH, you are not paying for that growth. With a market capitalization of $6.3 billion and net debt, including leases, of $2 billion, the market values the business at ~14x of the normalized EBIT of $595 million. From the perspective of an equity holder, you’re paying 19x normalized earnings or 5.28%. This is roughly a 1.5% spread compared to the 3.75% 10-year treasury yield. Receiving a 1.5-point premium to the 10-year for a business whose operating power will compound at high rates of return over the next decade is not a bad deal. Furthermore, I believe the actual operating earnings power exceeds what the business delivered in the last annual report. Over the past year, a powerful cyclical headwind in the luxury housing market has drastically reduced demand.

According to Redfin, while home prices have maintained high levels, home sale volumes have plummeted in 2023, falling by 45% YoY, reflecting a significant bid-ask spread discrepancy between buyers and sellers. This cyclical force severely impacts RH since a significant catalyst for an individual buying furniture is a home purchase. Furniture companies like RH gain substantially when such home sales occur, as homeowners tend to spend about 10% of the total home purchase price on furnishing.

The macroeconomic turbulence of 2022 is vividly reflected in the steep decline of membership counts for that year. Members, who account for a substantial 97% of the total revenue, plummeted by 23.53%, underscoring a dramatic decrease in furnishings demand. Paradoxically, amidst these challenging times, the increasing customer loyalty and resilience of the business were highlighted by a significant boost in average revenue per member, which surged by 23.6%.

Inverting the Thesis: Addressing the Main Risks

As RH ventures further into the luxury market, it faces the challenge of reduced market share due to its focus on a narrow customer base of global millionaires. Nevertheless, this affluent demographic holds a growing $221.7 trillion of the world’s wealth, which opens up considerable opportunities.

Fending off established luxury brands and establishing a global presence present additional hurdles. It may require spending substantial marketing dollars, considering its limited brand awareness. With the North American market nearing saturation with 67 design galleries, RH is banking on inventive domestic transformations and international expansion. Instead of traditional advertising, the company intends to create standout experiences to impress consumers and promote organic brand recognition.

The company’s supplier relationships, based on mutual trust rather than formal contracts, could also pose a risk. However, this unique approach nurtures strong ties with vendors and focuses on distinctive designs and quality, ensuring resilience against competitors. Additionally, RH often represents 50% to 80% of a vendor’s business. This dependency situates RH in the driver’s seat, granting it substantial influence over vendors and reinforcing the mutually beneficial relationship.

Lastly, concerns about brand dilution due to growth and clearance strategies are worth considering. Still, examples of luxury brands managing extensive retail networks without losing appeal and the necessity of clearance practices for efficient inventory transition to move further upmarket suggest this may not be a significant concern for RH.

Conclusion

Wrapping up, RH shines brightly as a powerhouse luxury home furnishings business. Its unique knack for setting trends, along with an intelligent approach to capital allocation, has helped it carve out a special place in the market. The company’s adventurous leap into luxury travel and housing shows its commitment to creating a complete lifestyle for its customers. Challenges are ahead, such as expanding globally and competing with well-established brands. However, RH’s innovative spirit and dedication to creating unforgettable experiences put it in a strong position for future growth. Investing in RH doesn’t come with a hefty price tag, making it an appealing choice. With its robust business model, exciting plans for the future, and potential for rewarding returns, RH truly stands out as a remarkable company and a fantastic long-term hold for the enterprising investor.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.